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Read This Before You Bet Against the Rally

Stocks that many are betting against are still soaring.

The rally in stocks has saved many portfolios from the brink of oblivion. But not everyone's happy about just how far the stock market has gone up in the past year. If you've been betting against the market and particular stocks, this rally is driving you crazy -- and there seems to be no relief in sight.

The dark sideMost people approach investing in simple terms. They have a certain amount of money to invest, and they look for investments to buy that will produce a reasonable return on that money. When they believe that an investment they own has topped out and may start to decline, then they sell their shares and look for another investment to take its place.

But as many people discovered during the 2008 bear market, there's a way you can profit when shares of a stock go down. By selling short shares of a particular stock, you make $1 of profit for every $1 that the stock price falls.

Here's how it works: When you decide to sell a stock short, your broker finds a shareholder who's willing to lend you shares of that stock. Then you borrow the stock, sell it in the open market, and get cash proceeds in return.

When you're ready to close your trade, you buy back the shares, and your broker returns them to the investor you borrowed them from. From your perspective, you'd like the price of the stock to fall during the time you've sold short. That way, you pay less when you buy back the shares than you received when you initially sold them -- and you get to pocket the difference as profits. If the stock goes up, however, you'll have to find the extra money for those shares out of your own pocket, and you'll suffer a loss.

A kick in the shortsRight now, many of the most-often shorted stocks have thwarted investors by rising during the rally, sometimes strongly. Here's a sample:

Stock

Current Short Interest (Shares)

1-Year Return

Citigroup(NYSE: C)

523.5 million

15.2%

Ford Motor(NYSE: F)

182 million

197.4%

Qwest Communications(NYSE: Q)

122 million

54.7%

Sirius XM(Nasdaq: SIRI)

109.7 million

174.3%

Level 3 Communications(Nasdaq: LVLT)

108.5 million

64.1%

Sources: Wall Street Journal, Yahoo! Finance. Short interest figures as of March 31; returns as of April 13.

This time last year, these bets seemed like reasonable positions to take. Many thought the rally would be short-lived and that continuing economic troubles would destabilize the financial system enough to hurt both financial institutions such as Citi and the businesses that relied on their financing. In particular, Sirius openly explored the possibility of filing for bankruptcy protection. Many thought Ford would be fatally hurt by GM and Chrysler, given their respective bankruptcies. Even now, Level 3 remains unprofitable, and Qwest's checkered past and improbably high dividend yield make it a target for shorts.

Not every big short bet has turned out badly, though. Popular shorts Sprint Nextel(NYSE: S) and E*Trade Financial(Nasdaq: ETFC) have both missed out on the rally over the past year, as they both have dealt with the same problems as their industry peers.

But overall, it's been a tough year for short-sellers. Because the losses from short-selling aren't defined by any amount you originally invest -- theoretically, your losses are completely unlimited -- long-term short-sellers can take big hits when things don't go their way. Under some circumstances, that situation leads to short squeezes, as short-sellers panic to buy shares to close their short positions and end up pushing the stock price dramatically higher. That situation can spell opportunity for those willing to bet against the shorts.

Be careful out thereAt the right time, shorting stocks can be a great way to make money in a tough market. But learn from the lessons that short-sellers have been taught during the rally by making sure you're prepared for what can happen if the drop in share prices you expect doesn't come to pass.

If you'd rather not give in to the dark side, Fool contributor Jordan DiPietro has the answer. Check out the one stock he thinks is the best dividend stock, period.

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Author

Dan Caplinger has been a contract writer for the Motley Fool since 2006. As the Fool's Director of Investment Planning, Dan oversees much of the personal-finance and investment-planning content published daily on Fool.com. With a background as an estate-planning attorney and independent financial consultant, Dan's articles are based on more than 20 years of experience from all angles of the financial world.
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